The stock market’s business district is where small stocks and value stocks tend to reside. Because of their risk characteristics (i.e. higher risk), those companies offer higher expected returns than their large stock and growth stock counterparts. But, they tend to be riskier than the average stock.

Since risk and return are related, you want to make sure your portfolio has an appropriate level of exposure to the business district.

The research is clear: stocks in the business district are smaller and cheaper relative to their accounting measures than the average stock is. That’s why stocks in the heart of the business district are called “small value” stocks.

Years ago, I had the good fortune to spend time fly fishing with one of the sport’s greats, Joe Humphreys. Already a legend in the late 1980s when I arranged to take some lessons from him, Joe was generous with his time and took me all over central Pennsylvania to teach me a wide range of fly fishing tactics. I remember that we concentrated on nymph fishing. Nymphing is when the fisherman presents his fly under the surface of the water—at just the right depth–and at a speed that does not arouse the fish’s suspicion. It requires concentration and special skill to be at the right place at the right time.

When nymph fishing, one of your biggest concerns is making sure your fly is actually “making it down to the fish.” Little lead split shot that’s crimped to your line will help the fly descend to the correct depth– the stream’s “business district” as Joe called it.

The business district is the depth at which the trout suspended themselves in the water as they wait for the current to bring them food. With Joe’s guidance, my fishing steadily improved. Now, every time I nymph fish, I ask myself if my flies are truly making it into “the business district.” As regular readers of this blog already know, the stock market, like a trout stream has a business district. And, that’s where you want to be.

The stock market’s business district is small stocks and value stocks tend to reside. Because of their risk characteristics (i.e. higher risk), those companies offer higher expected returns than their large stock and growth stock counterparts. Risk and return are related. As a result, you want to make sure your portfolio has an appropriate level of exposure to the business district because that exposure is a very significant factor in the long term expected return of your portfolio.

So where is the business district?

The business district in the stock markets is where you’ll find companies with the highest cost of capital. Since a companies’ cost of capital and the investor’s expected return are equal, companies in this sector offer the highest expected return. It is just a matter of economics. The research is clear: stocks in the business district are characterized as being smaller and cheaper relative to their accounting measures than the average stock in the market. That’s why stocks in the heart of the business district are called small value stocks (see chart below).

The chart below, highlights the returns of stocks in the business district in yellow. As you can see, stocks in the business district have offered much higher returns than the rest of the market over the long term.

However, as you can see in the next chart, these high performing stocks have been riskier for investors. Risk is this case is measured by the annual standard deviation of returns which simply measures the degree to which returns vary year by year. The larger the number the more variable the return.

But, for patient investors, the extra risk associated with owning stocks in the business district has been very rewarding. The last chart illustrates the growth of a dollar invested in each area over the period of July 1926 thru September 2014.

This is a great example of the power of compounding. But before you call your advisor and ask him or her to increase your portfolio’s exposure to small value stocks, I must offer a word of caution. The data here covers a very long period of time. Over shorter time periods, stocks in the business district can (and have) underperformed. Sometimes by a very large margin. But if you have a time horizon of 10 years or so, you may want to consider tilting your portfolio toward stocks in the business district. For more on this topic, please see our video or contact me at cboinske@independenceadvisors.com.